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RBI should stay the course

RBI should stay the course
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First Published: Tue, Sep 14 2010. 09 30 PM IST
Not much has changed in the last two months for the Reserve Bank of India (RBI) to alter its course of action on normalizing policy rates. There has been some debate on whether the central bank should take a pause in its 16 September review. The two points feeding into this debate are the growth conditions in the Indian economy, domestic and external, and the inflation situation. Both point in the direction of continued increases in policy rates, for now at least.
Consider growth first. The economy has had two quarters of robust growth this year. From January to March, gross domestic product (GDP) grew by 8.6% (at factor cost). From April to June, GDP grew by 8.8%. At this time, continuing uncertainty in the global economy and the possibility of a growth slowdown, even marginal, in the later part of the year, are real. This, however, cannot be a ground for taking a “pause” in the rate tightening cycle. The reason is simple: Even in the worst phase of the global economic recession, when output fell by close to 3-4 percentage points, the Indian economy continued to post strong growth. It never fell below the 5% mark in any quarter. One reason for this strength was strong demand. Anecdotal evidence from expenditure-side GDP estimates show that private and government consumption continues to be robust. This data should be taken with a pinch of salt. But whatever it is worth, it shows the direction in which things are moving.
Which brings us to the key point: Strong demand is coupled with continuing inflationary pressures. On Tuesday, the Union government released a new Wholesale Price Index (WPI) series with 2004-05 as the new base year, instead of 1993-94. WPI inflation, as measured by the new series, fell marginally to 8.5% in August from 9.8% in July. Under the old series, the drop is less sharp, at 9.5% from 9.8% in July. Even under the new series, WPI inflation is 275 basis points (bps) higher than the repo rate. Clearly, there is space for an increase of at least 50-75 bps in policy rates. Anchoring inflationary expectations in the face of monetary transmission problems requires that this gap be minimized.
These factors make it clear that RBI needs to stay the course of normalizing its policy rates. The question, as always, is by how much. The answer depends on choosing a course that is not disruptive to the markets. A 25 bps increase in both the repo and reverse repo rates would be a step in that direction.
Will inflation ease in the coming months? Tell us at views@livemint.com
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First Published: Tue, Sep 14 2010. 09 30 PM IST
More Topics: Ourviews | RBI | GDP | Recession | Views |